Getting the most out of your call options

October 13, 2010 | BY

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As PRC private enterprises are increasingly looking outward for investment, many shareholders are using the call option scheme to hold interests in overseas companies. But before any proceeds can be obtained, investors will encounter complexities in the Chinese foreign exchange legal procedures and need clarifications on implementation

As per various merger and acquisition laws, restrictions on round-trip investment, examination and approval procedures for overseas listing and other related laws, when PRC private enterprises seek overseas financing by means of overseas listing, some PRC controlling shareholders realise their rights and interests in an overseas-listed company by means of entrusting foreign entities or individuals to hold their shares of said company (or in shares in shareholder entities of said company). This type of arrangement is often set up or executed in coordination with a call option scheme that will enable the PRC individuals to directly hold shares in the overseas company at a later point. In such a situation, one of the more difficult issues encountered is how to go through the foreign exchange legal procedures under PRC laws and regulations in order to ensure that those domestic individuals legally possess the overseas interests of such shares and that the proceeds from overseas with regards to the call option plan can be obtained.


Typical legal structure and applicable PRC laws and regulations

The typical overseas legal structure with the call option plan is as follows:


(1) Company A, a PRC company, is controlled by X, a PRC resident individual, and X is working for Company A;

(2) Company B, a wholly foreign-owned enterprise (WFOE) incorporated in the mainland of China by Company C, controls Company A based on series of agreements;

(3) Company C is incorporated in the British Virgin Islands (BVI) or Cayman Islands by Y, a non-PRC resident individual, who acts as a nominee on behalf of X, and C is listed in an overseas stock exchange (such as a USA stock market);

(4) X and Y enter into a call option agreement, stipulating that X has the right to purchase the shares of Company C held by Y within a certain period subject to the satisfaction of various conditions.


According to current PRC laws and regulations, the foreign exchange laws and regulations related to the above call option plan include, but are not limited to:


(1) PRC Foreign Exchange Control Regulations (Revised) (中华人民共和国外汇管理条例) (Foreign Exchange Regulations) revised on August 5 2008;

(2) Foreign Exchange Control Measures for Individuals (个人外汇管理办法) (Decree of the People's Bank of China 3 [2006]) (Decree 3) (中国人民银行令[2006]第3号);

(3) Implementing Rules for Foreign Exchange Control Measures for Individuals (个人外汇管理办法实施细则) (No.1 [2007] of the State Administration of Foreign Exchange) (Circular 1)(汇发[2007]1号);

(4) State Administration of Foreign Exchange, Circular on Issues Relevant to Foreign Exchange Control with Respect to the Round-trip Investment of Funds (国家外汇管理局关于境内居民通过境外特殊目的公司融资及返程投资外汇管理有关问题的通知) (No.75 [2005] of the State Administration of Foreign Exchange) (Circular 75)(汇发[2005]75号);

(5) Operating Rules for Foreign Exchange Control in Connection with the Participation in Employee Stock Ownership Plans and Share Option Schemes of Overseas Listed Companies by Domestic Individuals (境内个人参与境外上市公司员工持股计划和认股期权计划等外汇管理操作规程) (No.78 [2007] of the State Administration of Foreign Exchange) (Circular 78) (汇综发[2007]78号);

(6) Circular on Operating Rules for Direct Handling of Capital Account-related Foreign Exchange Transactions by Designated Foreign Exchange Banks (Hui Zong Fa No. 77 [2009]) (Circular 77) (关于外汇指定银行直接办理资本项目外汇业务操作规程的通知)(汇综发[2009]77号;

(7) General Affairs Department of the State Administration of Foreign Exchange, Circular on Delegating the Examination and Approval Authority to Lower Levels over Limits on Purchase and Payment of Foreign Exchange for the First Time and Opening of Foreign Exchange Accounts for Participation in Employee Stock Ownership Plans and Share Option Schemes of Overseas Listed Companies by Domestic Individuals (No.2 [2008] of the State Administration of Foreign Exchange) (Circular 2 ) (国家外汇管理局综合司关于下放境内个人参与境外上市公司员工持股计划首次购付汇额度及开立外汇账户审批权限的通知)(汇综发[2008]2号); and

(8) State Administration of Foreign Exchange, Circular on Revising the Examination and Approval Authority for Certain Capital Account-related Foreign Exchange Transactions (No.29 [2010] of the State Administration of Foreign Exchange) (Circular 29) (国家外汇管理局关于调整部分资本项目外汇业务审批权限的通知)(汇发[2010]29号).


Relevant legal requirements for foreign exchange operation

1) Disclosure and filing of the call option scheme(s) and foreign investment registration

According to the provisions and requirements of Section 2 of Circular 75 and Section 2.8 of Circular 77 issued by the State Administration of Foreign Exchange (Safe), the incentive plans for the management with regards to stock option schemes is not required to seek examination and approval with the local branch or department of Safe of the place where he or she resides (collectively “Safe Department”). However, prior to the establishment of Company C, an overseas special purpose venture(s) (SPV) as defined under Circular 75, X shall apply for the foreign exchange registration of overseas investment with the Safe Department. As the call option agreement entered into by X and Y shall be deemed as a stock option scheme (SOS) as set forth under Circular 77 and 78, X shall: (a) disclose the call option agreement in its business plan for overseas financing, which shall be submitted at the time of going through the procedure of foreign exchange registration of overseas investment; (b) file the call option agreement with the Safe Department for record; and (c) modify registration of the overseas investment when X exercises its call option right under the terms of the call option agreement.

In addition, according to the provisions of Circular 2 and 29, in the case where X repatriates the capital and settles foreign exchange concerning the call option agreement, X may go through the procedure of examination and approval by the sub-branch of Safe which has been delegated by Safe.


2) Legal requirements for procedures concerning exercise and sales of the stock under the SOS

According to the provisions of Article 18 of Circular 1 and Circular 78, the operation of foreign exchange matters with regards to the call option agreement executed by and between X and Y shall be handled by a domestic agency or Company A entrusted by X. Such foreign exchange matters include the following tasks: filing the call option agreement for record, application for purchase and payment of the foreign exchange, or opening a specialised domestic account for foreign exchange. In the situation where the call option has entered into the exercise period and X exercises his or her call option in cash, Company A or the domestic agency shall, on an annual basis, apply to the Safe Department for the quota of foreign exchange purchase and payment. In the case where X exercises his or her call option on a non-cash basis, Company A or the domestic agency shall apply to the Safe Department for a specialised domestic account for foreign exchange.


3) Legal requirements for procedures for managing the income of foreign exchange realised from the SOS

According to the provisions of Article 18 of Circular 1 and Circular 78, subject to X satisfying the legal requirement stated above, X can settle income from dividends or income from the sale of shares. These are obtained according to the call option agreement or X can remit such income to his specialised domestic account opened by the domestic company or the domestic agency entrusted by X.


4) Liabilities for violation of the relevant PRC laws and regulations concerning foreign exchange

According to the relevant provisions under Circular 78, where any domestic individual, domestic agency, domestic company the individual works for, asset manager or other domestic company that violates these regulations under Circular 78, the Safe Department will (1) according to Foreign Exchange Regulations, Decree 3, Circular 1 and other relevant regulations, give the relevant party a warning and demand a correction to the violation and levy a fine of less than Rmb 300,000 to an institution and less than Rmb 50,000 to an individual; and (2) impose a fine of less than Rmb 30,000 on a bank and less than Rmb 1,000 on the domestic individual, respectively, where there is no other explicitly stated fine under Foreign Exchange Regulations and other relevant laws or regulations.

Moreover, according to Circular 77, the domestic enterprise shall not pay an SPV which has not completed the foreign investment registration, the amount of any profit, the transfer of equity, reduction of capital, return in advance on investment, liquidation of the proceeds, and principal and interest of the shareholders' loan, otherwise the domestic enterprise will be treated as evading the foreign exchange laws and be punished accordingly.


Unclear issues in connection with practical operation

As discussed above, there are various legal requirements for domestic individuals holding call options of overseas companies. However, in practice, there still remain some unclear or inconsistent issues on the current regulations. For example, Section 2.8 of Circular 77 is applied to the enterprise option plan of an SPV, but it does not specify whether the SPV it refers to is an overseas listed company or not. This is different compared to Circular 78 and Article 18 of Circular 1 which specifically states that an “overseas listed company” under these regulations refers to companies listed on an overseas stock exchange.

Some Safe Departments hold the opinion that Circular 78 is not applied to the SOS carried out by an overseas unlisted company and therefore it is not necessary for stock option scheme holders of unlisted overseas companies to go through the filing procedures with the Safe Department. In such a case, these individuals may face the risk that the exercise of the call option and settlement of the foreign exchange will be deemed as lacking required legal procedure. Therefore, it is necessary for the relevant government authorities to further issue relevant implementing rules indicating whether Circular 78 shall be applied to the SOS of overseas unlisted companies, as well as to the domestic individual indirectly holding the option of the overseas listed company. Relevant implementing rules should also be issued on how to go through the foreign exchange procedure for such an SOS. Furthermore, in the situation where an SPV(s) establishes the SOS after its own establishment, there are no specific regulations that set forth specific relevant procedures for registering such an SOS. It is also necessary for the relevant government authority to issue additional rules or regulations setting forth the foreign exchange procedure concerning the details of carrying out such SOS operations.


Juan (Jane) Yang and Lihua (Irene) Yang, Grandall Legal Group, Beijing

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